Sunday, 19 February 2017

OPEC’s
strategy has worked so far, but could end up being self-defeating.

OPEC surprised
markets on 30 November 2016 by agreeing
to cut oil production in an attempt to support prices. The cuts were meant to
reduce OPEC’s production by roughly one million barrels per day (mb/d), effective
from 1 January 2017. Data released in the last few days provide the first test
about whether the cuts have been successfully implemented. The bottom line is
that: compliance has been high helping prices to move up; the overall movement
was beneficial for the finances of OPEC members; but could prove to be short
lived as it gives a lifeline to US shale producers, who are likely to ramp up
production and depress prices. Below I elaborate on these points.

1. OPEC members have
complied with the agreed cuts. The latest data show that production fell to 32.1 mb/d,
lower than the 32.5 mb/d ceiling that had been agreed on. Every single country
reduced its production compared to October 2016 levels (see chart). Some have
made substantial reductions as in the case of Saudi Arabia, which lowered its
production by 598 kb/d.

2. The cuts have moved
oil prices to a new and higher range. While oil prices hovered around $45 per barrel before
the cuts, they have been fluctuating around $55 per barrel since the agreement.
This represents an increase of about 22%.

3. The cuts have so far benefited OPEC
finances as the gain in prices more than offset lower production. The rise
in prices has far exceeded the cuts in production. For example, Saudi oil output
has fallen by 6% since last October, while prices have risen by 22%. If current
prices and production were to be sustained for the whole year, Saudi oil revenues
would be higher by around $27bn compared to what would have happened without
the deal.

4. But higher oil
prices may not be sustained as US shale oil could make a comeback. Higher oil prices
are making US shale oil profitable again. US production
rose in December after several months of continuous decline. The International
Energy Agency is reporting increased investment in US
shale oil, implying more supply to come in 2017. Higher US supply would
lead to lower prices, reversing the gains made by OPEC cuts.

In conclusion, OPEC
successful implementation of production cuts has pushed prices higher and
benefited the revenues of its members. But the strategy could be self-defeating
as it is giving US shale oil producers a lifeline to increase their production
and depress prices again. If this does happen, then OPEC would either be required
to support prices by making further cuts or make a U-turn on its strategy.

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About Me (Ziad Daoud)

I am an economist currently based in the Middle East. I have previously worked for an asset management firm and, before that, I did a PhD at the London School of Economics. The views in this blog are solely my own.